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In our tech-heavy Pacific Northwest, many companies grant stock or stock options as part of an overall compensation package. These equity incentive programs can seem like a windfall but, as with any source of income, they must be carefully managed so they don’t disrupt your financial plan or create a major tax headache.

The three most common programs we see are RSUs, ESPPs, and ISOs. While these can be confusing and overwhelming at first, if you work for a company with one or more of these programs, you can’t afford to overlook them.

To plan successfully, you’ll need to understand three issues – what kind of program you have, how your options are taxed and how you plan to incorporate your shares into your overall financial plan.

 
How RSUs (and RSAs) Work

Restricted Stock Units (RSUs) and Restricted Stock Awards (RSAs) are similar, with a few subtle differences. With an RSU, you are given the “value” of a share of stock, but not the stock itself so you won’t have any voting power or receive dividends (though some companies can pay a dividend equivalent). With an RSA, you get the actual stock, so have a vote.

These are most often awarded annually as part of your annual performance review. Most RSUs and RSAs come with a vesting schedule, meaning you don’t get the full value right away. For example, if Amazon awards you 100 RSUs, you’ll likely have 25 shares vest each year until the full 100 shares is vested in four years.

Tax Treatment

What many people fail to realize is how this type of compensation is taxed. For RSUs and RSAs, when the 25 shares vest, they will show up as a line item on your paycheck and you’ll pay taxes like the rest of your income

At this point, you can sell the stock and keep the proceeds since you’ve paid taxes on it. Or, you can hold onto the stock and you’d owe capital gains taxes on anything you’ve earned since the vesting date.

Investment Allocation Strategy

One thing many of our clients initially struggle with are RSUs that, accumulated over time, results in a heavily consolidated position in one company without them realizing it. For example, a long-time Amazon executive might begin with 25 shares vested, and then 100, and another 300, and so on. Suddenly, they find they have $1 million or more net worth in Amazon stock, making up a significant portion of their holdings.

This results in a potential diversification issue, among other dangers. You might hold a high concentration of stock in one company, and it’s also the same company that’s giving you a paycheck. This could create a double whammy if something goes wrong with the company down the road.

In general, we like to see clients sell their RSUs and RSAs once they vest and reposition these funds into a more diversified investment portfolio. If they want to keep some company stock, we recommend setting a fixed number of shares they plan to hold to avoid the potential for bias to develop and ending up with too much of your net worth tied up in a single place.

 
How ESPPs Work

An Employee Stock Purchase Program (ESPP) is another program offered by publicly held companies. It allows an employee to purchase company stock at up to a 15% discount with a contribution limit of either 15% of their income or $25,000 each year.

Assuming you make $200,000, 15% of your income would be $30,000. But the IRS limits your spending on an ESPP to $25,000, so this would be your annual cap. To participate, you can defer a percentage of each paycheck towards the stock purchase program. Where it gets more complicated is with the taxation of these incentives.

Tax Treatment

Let’s assume you’re accumulating Microsoft stock at a 15% discount, meaning you’re already making a profit compared to the market price. From the perspective of the IRS, you can’t just turn around and sell that stock immediately without paying taxes.

According to IRS rules on ESPPs, you have to hold the stock for 24 months to get assessed the long-term capital gains tax of 15%. If you sell before this threshold, you’ll pay a short-term capital gains tax and standard FICA taxes on your gain, which can be substantially higher depending on your income.

What’s the Right Strategy?

In general, ESPPs are a great deal because you’re getting access to stock at up to a 15% discount (the percentage varies per company). But the strategy we recommend depends on each situation.

One the one hand, if you’re making $100,000 per year, not fully funding your 401k and have around $7,000 in monthly expenses, there might not be much leftover at the end. But, if possible, we might still recommend deferring even 2% to 4% of each paycheck towards your ESPP.

Conversely, if you’re making $500,000 per year, maxing out your 401k and have plenty of cash left over at the end of the month, we’re likely to recommend putting the full $25,000 into your ESPP each year to take advantage of the discount.

As with your RSUs and RSAs, we’d still recommend limiting how much of this stock you keep and allocating the rest to a diversified portfolio once you pass the 24-month long-term gain required hold period.

 
How ISOs Work

Incentive Stock Options (ISOs) are the last of the most common equity incentive program. But this one seems to be fading into the background in favor of RSUs and ESPPs over the past several years.

An ISO offers you the “option” to purchase company stock at a set price, called the “strike price,” within a defined period. Like RSUs and RSAs, ISOs are usually subject to a vesting schedule which can be as long as 10 years. The kicker with stock options is that, if you don’t exercise them and they expire, you’ll lose them.

Vesting of ISOs

Let’s assume you’re given the option to purchase 25 shares of Amazon at $1,500 a share over the next year. When your option can be exercised, Amazon is trading at $2,000 a share. The good news is that you don’t have to bring $50,000 to the table for the stock purchase. Instead, you’ll usually have two choices. If you want to hold the shares, you’ll have to come up with the $37,500 – 25 shares at your set $1,500 price – and you get to keep the $500 gain on each share. Or, if you just want the proceeds, many companies allow a “cashless” exercise choice and, in the example above, you’d receive the $12,500 gain in cash.

Tax Treatment

Assuming you buy those 25 shares of Amazon stock at the $1,500 strike price, you have an instant $12,500 gain if the stock is trading at $2,000 a share. But that gain isn’t in the bank if you haven’t sold the stock.

From a tax standpoint, you’ll likely want to hold it for 12 months to get long-term capital gains treatment. If you sell in less than 12 months, you’ll pay short-term capital gains taxes and FICA taxes on the gain, as we saw with ESPPs.

 
Other Types of Stock Options

A less common version of the ISO is the Non-Qualified Stock Options (NQSOs). These are generally paid out as executive and director-level compensation. They are still active stock options but don’t have some of the same benefits as ISOs when it comes to long-term capital gains.

When you exercise NQSOs, you pay ordinary income tax on the difference between your exercise price and the current stock price. For example, if your strike price was $20/share and the stock was trading at $40/share, you would pay ordinary income tax on the $20/share gain. After exercising the options, additional gain is subject to normal short (if held less than 12 months) or long-term (if held more than 12 months) capital gain taxes.

What’s the Right Strategy?

The strategy we employ with clients that receive ISOs is similar to that of ESPPs. We generally recommend exercising the options as soon as they are vested and then holding them for 12 months to get the long-term capital gains benefit.

After a year, you’ll want to sell and reposition to a more diversified portfolio to avoid having too many eggs in the company basket.

Misconceptions and Considerations with Equity Incentive Programs

The most common misconceptions around equity incentive programs surround taxation and vesting issues. Some, such as RSUs, are taxed immediately and allow you to turn around and sell the stock directly. Others are vested on a schedule or require you to hold for a certain period to avoid unnecessary taxes.

We recently worked with a local tech executive. He had worked for the company for over a decade and held all the stock awards he accumulated over the years. When we began our work together, he had about $3 million in net worth, but 75% of that was in company stock. Not only was there a diversification issue, but a huge tax burden to deal with, making things more complex.

But even complications like these open up opportunities. And there are plenty of opportunities for people who have highly appreciated stock, particularly for anyone already making sizeable charitable donations.

Equity incentive programs provide you with the means to build additional wealth outside your normal compensation through your paycheck. But they also pose significant risk to your financial plan because of diversification and tax issues.

If your employer offers these unique and valuable benefits, it’s always a good idea to reach out to an experienced financial planner that can help you create a sound strategy to maximize your wealth.

Contact us to learn more!

Alterra Advisors - Josh Whelan

Ryan Colis

CFA, CFP®
Partner, Financial Advisor

About the Author

Ryan is a problem solver. He has a distinct ability to create a simple solution for very complex puzzles. So, naturally, he’s an integral part of our team. His favorite part of his role at Alterra is the analysis – whether analyzing a financial plan or reviewing an investment portfolio. However, the profession allows him to share that passion with clients by helping them navigate financial complexities as they collaborate on achieving their personal and financial goals.

After completing his undergraduate degree in Business Management, Ryan and Grant met by chance, developed a rapport and have been working together ever since. Ryan has continued his formal training in finance by earning his CFP and CFA designations.

The “Alterra” name was coined by joining the Latin roots “alter”, the origin of the word “altruism” with “terra” meaning earth or land. This name reflects the company philosophy of “clients before profits” and providing firmly grounded advice.

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